Chicago’s Rajan Says U.S. Needs ‘Less Aggressive’ Fed Policies

Feb. 11 (Bloomberg) -- The Federal Reserve, under political
pressure to combat unemployment, risks creating financial
instability through its record monetary stimulus, according to
University of Chicago Professor Raghuram Rajan.

“A more stable and less aggressive U.S. monetary policy
will not only lead to more stable U.S. growth; it will also
reduce the volatility of capital flows coming into and out of
emerging markets,” Rajan said in a paper scheduled to be
published in the March/April issue of Foreign Affairs. He
predicted the financial crisis two years before it hit.

The Fed’s Nov. 3 announcement that it would buy $600
billion of bonds through June sparked some of the bitterest
political criticism in three decades. Republican lawmakers and
officials in China, Germany and Brazil said the so-called
quantitative easing may weaken the dollar and ignite inflation.

The decision to embark on another round of quantitative
easing was “questionable” because the Fed’s benchmark rate was
already near zero and companies were able to borrow at “very
low rates,” said Rajan. Consumers were also holding back
because “their balance sheets were in disarray,” not because
interest rates were too high, he said.

The U.S. central bank is under “enormous” political
pressure to be “adventurous with monetary policy” because the
unemployment rate is high, yet its policies are unlikely to
restore jobs lost as a result of the collapse of the housing
market, said Rajan, a former International Monetary Fund chief
economist.

‘Aggressive Policies’

“Such pressure can be counterproductive if the Fed’s
aggressive policies have little direct effect on employment but
instead generate asset price bubbles and risky lending, which
eventually impose high costs on the economy, including greater
unemployment,” Rajan said.

The unemployment rate fell to 9 percent in January from 9.8
percent in November. Joblessness rose above 9 percent in May
2009, beginning the longest period of unemployment at that level
or higher since monthly records began in 1948.

“The Fed’s mandate should be extended to include financial
stability explicitly, on par with its current responsibilities
to keep inflation low and maximize employment,” Rajan said.

The U.S. also should have a “better social safety net,”
such as unemployment benefits, “not only to reassure workers
but also to ensure that slow recoveries do not result in
frenetic, and ultimately excessive, stimulus spending,” he
said.

‘Real Dangers’

The Fed’s policies create “very real dangers” around the
world because other countries imitate the U.S. central bank by
lowering interest rates as they don’t want their currencies to
appreciate against the dollar, he said.

“What is appropriate for a U.S. economy that is recovering
slowly from a recession may be overly aggressive for emerging
markets that are near full employment, creating inflation and
asset bubbles in those economies,” Rajan said.

“Over the medium term, if the United States embraces its
role as spender too readily, as it seems to have done in the
recent past, it risks jeopardizing its creditworthiness -- not
even the United States can borrow forever to fund spending,” he
said.